Can Islam and free markets co-exist?

This question is asked by Benedikt Koehler at the IEA blog. Koehler argues that they can co-exit, in fact he says that the pro-business approach of Mohammed and his successors helped turn early Islamic societies into the most dynamic economies of their time. Koehler goes on to write,

Islam and entrepreneurship

Mohammed was an orphan who had to pay his way in life. Whilst Buddha and Jesus were conspicuously indifferent to acquiring wealth, Mohammed encouraged his adherents to engage in business and deemed acquisition of wealth meritorious. He was born in Mecca, a city located in a barren valley whose population had as its sole useful natural endowment a black rock that attracted pilgrims from all over Arabia because it was believed that Abraham had built an altar on that cube, the kaba. The coming and going of pilgrims offered opportunities to trade and do business. This communal business had been operational for many generations when Mohammed was born in 570.

Mohammed was born into a family of leading Meccan traders. He was around ten years old when his uncle took him on his first caravan journey and married an entrepreneur when he was 25. When Mohammed found his calling as Allah’s Apostle, he emigrated to Medina to set up a community on Islamic lines. One of Mohammed’s first actions in Medina was to set up a market. Raising the standard of living through trade, after all, was what he was familiar with. Indeed the Koran exhorted Believers that gold should be put to productive use.

Mohammed died in 632 and the boundaries of the Islamic empire expanded within decades to encompass the entire Middle East and most of North Africa. A large trade zone emerged governed by Islam’s ruler, the caliph. Long distance trade became easier once borders fell away. By the end of the seventh century, the caliphs introduced a gold standard that powered investment activity. The caliph’s mints used bullion from Arab gold mines, church treasuries in former Byzantine lands, and Pharaonic gravesites in Egypt.

Islam and the rule of law

Market economies cannot thrive without a supportive legal framework and respect for private property. Mohammed’s first successor, the caliph Abu Bakr, made clear in his acceptance speech that his authority was that of a deputy to Mohammed (caliph means deputy) and he did not assert the right to construct laws arbitrarily. He would forfeit his right to govern were he ever to deviate from what the teachings of the Prophet. Abu Bakr thus set a precedent – a ruler is bound by laws too. Medieval Arab lore abounds with anecdotes about Abu Bakr’s and his successor Umar’s integrity. Both were extremely conscientious in avoiding conflicts of interest and pre-empting accusations of nepotism. Umar personally punished his sons in public to show they had to comply with the same laws as every other citizen. Indeed, Umar asked each senior government official to disclose his personal assets before taking up a senior appointment and to explain any sudden increase in wealth. Umar fired corrupt officials on more than one occasion, including the army’s commander-in-chief Khalid al Walid.

Early Islamic judges were known not to countenance even the appearance of accommodating the government. Exemplary anecdotes of judicial independence from the executive were passed from generation to generation reading the classic collection of tales in Arabian Nights. In one such story, the famous jurist Abu Hanifa declined an invitation to work for an administration where he might compromise his standard of integrity, because, as he made it known to the caliph, ‘how can I enter the water without getting wet?’. The Arabian Nights gather many other instructive anecdotes explaining a nuanced understanding of the interdependence between low taxes, entrepreneurial freedom and political liberty. The Arabian Nights’ narrator Shahrazad told her royal husband (and all her readers) how good governments are run: ‘Religion depends on the king, the king on his troops, his troops on money, money on prosperity, and prosperity on justice.’ The Arabian Nights feature many other examples of good and bad governments, showing that early Islamic societies had a very articulate educated class voicing opinions on public affairs. Islam’s fundamental pro-business stance was not controversial. Mohammed was remembered to have given sound investment advice: ‘There is nothing wrong in wealth when a person is God fearing, but health is better than wealth for the God fearing, and cheerfulness is a blessing.’

The rise and fall of the Islamic empire

The early Islamic empire grew very quickly and Arab Muslims were a minority that was vastly outnumbered by Christian and Jewish subjects. The early caliphs had no option but to rely on non-Muslims to staff their administration, collect taxes and negotiate treaties. The integration of a vast region, and the scope for professional advancement of a vast talent pool, engendered dynamic economies and spawned rapid urban growth. Baghdad in the tenth century was the world’s largest city.

Some Islamic scholars and lawyers pined for a return to the simplicity of Islam’s early days and had reservations about the luxurious lifestyle of the Muslim upper classes. But they could not point to a single Koranic injunction to compel Muslims to stop pursuing business opportunities and enjoying the rewards of successful investments.

Tenth century Baghdad afforded a much higher standard of living than European cities. Medieval Islamic societies were the most advanced economies of their time and their prosperity seemed assured. Manufacturing and agricultural innovations from Islamic societies found their way to Europe, including manufacturing paper and growing oranges.

Islam’s golden age ended after crusaders attacked from the West and Mongols from the East. There were economic reasons for decline, too. Once new trade routes were found trade no longer depended on traversing land routes across the Middle East. The drive to build new markets overseas sidelined the Arab world.

But the long-term effect of these external shocks was not as pernicious as the enfeeblement of entrepreneurial energy wrought by a combination of self-inflicted factors. Islamic societies lost the ambition to lead the world in scholarship and science and the loss of integrity of ruling classes was even more damaging. Entrepreneurs had no incentive to build a business once more money could be made from seeking favours from whoever happened to be in power. Rent-seeking became more remunerative than investment. Civil institutions and personal initiative withered.

The reasons for the economic decline of the Islamic world is one of the big questions in economic history. Timur Kuran discusses the issue at length in his book "The Long Divergence: How Islamic Law Held Back the Middle East". When looking for reasons for underdevelopment lets start with what Kuran does not see as causes; he doesn't argue is that colonialism or geography are the causes of underdevelopment or that there is some incompatibility between Islam and capitalism. Roughly what Kuran does argue is that problems started around the tenth century when Islamic legal institutions, which had up until this time benefitted the Middle Eastern economy, began to act as a drag on development by slowing or blocking the emergence of central features of the modern economy. Such slowed or blocked features included private capital accumulation, corporations, large-scale production, and impersonal exchange. Such handicaps gave the West - which did develop these features - the chance to jump ahead in economic terms, an advantage it still has today.